Gauging the risk of stagflation | Calamatta Cuschieri

Markets summary

Stagflation is characterized by high inflation and low growth in economic activity or even recession.  The persistence of inflationary pressures in recent months in the United States and, to a lesser extent, in Europe, and the slowdown observed in various activity indicators have raised fears that the world economy is heading, in the most extreme scenarios, to a stagflation similar to that of the 1970s.  Fortunately, with the lessons learned at that time and the independence of central banks, the economic authorities today are better equipped to avoid a similar situation.

In the short term, high inflation figures continue to be attributed to temporary factors which although persistent, should dissipate as productive capacity increases.  By the end of 2022, inflation in the US is expected to be between 2.5% and 3.0% while in the Eurozone it is expected to be around 2.0%.  A good part of the increase in inflation in recent months is due to base effects and a faster recovery in demand than in supply as a result of bottlenecks, disruptions in production chains, and problems in the supply of raw materials and components.

Advances in vaccination and treatment of Covid-19 have made it possible to rapidly reactivate demand.  However, many production processes do not react just as quickly and need time to return to normal levels of activity and inventories.  The uncertainties are focused on how long it will take for supply to meet demand, given the possibility that new variants of the virus may appear with successive waves of infections.

However, there are also factors that may have more lasting effects and generate higher inflation rates this decade than in the previous one. These include changes in sectoral composition, as a result of the pandemic or digital disruption, mismatches in the labour market, the energy transition, and more inflationary fiscal and redistributive policies.

The key will be the ability to avoid spiraling increases in prices and wages, and a de-anchoring of expectations, which could require central banks to raise borrowing costs at a faster clip to rein in inflation with the risk that they may overact.  Central banks have sufficient room to avoid inflation rates persistently above their target, the de-anchoring of expectations, and financial and fiscal dominance.  But, when the time comes to raise rates, they will have to reassert their independence and dispel any doubts about their determination to guarantee their inflation targets, in the face of governments that will have to bet on budgetary stability, without conditioning the actions of central banks.

In terms of growth forecasts, the advanced economies are already past the months of strongest growth.  This slowdown is normal - the recovery cannot be expected to continue at rates similar to those observed during the rebound from the deep downturns of 2020.  All in all, the near-term consensus is that the growth in 2021 and 2022 in the US and Europe will remain above potential.  However, the medium- and long-term debate shows more diversity and more conflicting positions. 

On the one hand, there are those who think that scars of Covid-19, high debt levels, an aging population, de-globalisation, or the energy transition will reduce potential growth.  On the other hand, there are those who argue that these effects can be offset by the digital revolution, structural reforms and the increased investment needed to move to carbon-neutral economies.

In short, in terms of both inflation and growth, the economic authorities in the developed countries have room for maneuver in terms of available policies and time, to avoid mistakes and the materialization of stagflation risks in the future.  A margin that in the case of emerging economies is generally, more limited.


Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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